The far reaching implications of the audit regulatory initiatives
The European Union (EU) audit market reform began in 2010 with a European Commission consultation Green Paper entitled “Audit Policy: Lessons from the Crisis”. After this consultation process, the European Commission (EC) released its Proposals in November 2011. Then after nearly three years of discussion, the final pieces of legislation were published in the Official Journal of the EU in 2014:
The Directive 2014/56/EU on statutory audits of annual accounts and consolidated accounts, amending the Directive 2006/43/EC on statutory audits and containing a series of amended and new requirements governing every statutory audit in the European Union (hereafter referred to as “the Directive”);
The Regulation (EU) No 537/2014 on statutory audit of public-interest entities containing additional requirements that relate specifically to statutory audits of Public Interest Entities (PIEs) in addition to the ones stated in the Directive (hereafter referred to as “the Regulation”).
The laws are expected to apply from mid June 2016 and are in principle intended to improve audit quality and increase market efficiency in the provision of audit and audit related services throughout the European Union. Following the entry into force of the new Regulation 537/2014/EU on specific requirements regarding statutory audit of public-interest entities (hereinafter “the Regulation”) and of Directive 2014/56/EU amending Directive 2006/43/EC on statutory audits of annual accounts and consolidated accounts (hereinafter “the Directive”), Member States have two years to implement the new EU legal framework on statutory audit. The new rules will apply as of 17 June 2016.
This article seeks to analyse and discuss the impact that the new EU regulatory regime for audit undertaken by the European Commission will have on the accountancy profession in Europe.
The reform in essence
After three years of negotiations, the new European audit legislation was final in the spring of 2014. The legal texts, which entered into force in June 2014, bring many challenges for the audit profession and the European business environment at large. British Conservative MEP Sajjad Karim, who drafted the Parliament’s position on the audit reform package, said that the reform will have “positive ramifications not just for the audit market, but for the financial sector as a whole.”
Indeed the legislation seeks to open up the EU audit services market beyond the dominant “Big Four” firms and remedy auditing weaknesses revealed by the financial crisis. Its proponents are saying that the new rules will weaken the dominance of the “Big Four” audit firms however critics say the reform will be a paper tiger unable to break up the dominant position of the world’s four biggest audit firms.
Fayez Choudhury, CEO, the International Federation of Accountants (IFAC), believes that the last two decades have been a definitive era in the evolution of the accountancy profession. In the wake of major corporate scandals at the turn of the century, an international public debate arose on the need for more effective and well-considered regulation; this debate then reignited during the global financial and sovereign debt crises.
It is an accepted fact that we are still suffering from the aftermath of the global financial crisis. We are now in the eight year of the crisis. The leaders of the G-20 countries have called for global regulatory cooperation and collaboration, including the adoption of global accounting standards. Global regulators including the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO) have been worrying more and more about global audit quality. There are also growing concerns about the governance of audit standard setting, largely by the profession itself (with public oversight by the Monitoring Group and the Public Interest Oversight Board) and the effectiveness and structure of the global audit oversight bodies. Global initiatives are also being considered to improve audit quality. They could cover:
transparency reporting and ownership of audit firms;
a set of audit quality principles issued by regulators;
the development of a globally consistent system for measuring firm audit quality;
guidance to audit committees on their role to enhance audit quality; and
guidance on professional scepticism.
IFAC itself recently issued a statement calling for the G-20 to renew its focus on regulatory convergence, stressing that although high-quality global standards for financial reporting, auditing, and ethics exist, too many countries appear to be reverting to national policy-making agendas. Putting global convergence on the back burner practically guarantees that the global community won’t be ready when the next crisis hits.
To some, particularly those within the regulatory community, there was a conflict of interest in the profession setting standards, particularly those for accounting, auditing, and ethics. As a result, there was a gradual shift of some functions-such as auditor registration and audit quality inspection-to the regulatory community. In addition, regulators, other public authorities, and IFAC implemented standard setting reforms, focused on audit and assurance, ethics, and education, that responded to the needs of those using the standards as well as regulators.
Effect on the profession
Despite its noble objectives, Mr Jens Roder, Secretary General & CEO, Nordic Federation of Public Accountants notes that although the audit reform legislation will not become applicable until June 2016, it is becoming increasingly clear that these objectives are unlikely to be achieved to the extent originally envisaged by the legislators. Mr Roder likens the audit reform objectives to the vision that underpinned the coming into effect of the Lisbon Treaty in 2009.
This Treaty was need to help Europe realise its full potential by modernising and reforming the Union. The EU had just grown from 15 to 27 member states and it simply couldn’t continue to operate with rules designed for an EU of 15. The Treaty of Lisbon reinforces the Union’s capacity to act through strengthened external coherence, a broadened range of internal policies, more effective delivery of results and policy achievements for citizens, and modern institutions that work in a Union of 27. In addition, European businesses, including service providers and institutions, were to become more effective and efficient and able to operate seamlessly within the European Union.
Although these were great visions, which European legislators were committed to following, says Mr Roder, alas the latest legislation impacting the auditing and accounting profession, as well as the entities using the services of the profession, has largely failed to realise these lofty ideals. This is a major cause for concern.
A study on the effects of the implementation of the acquis on statutory audits of annual and consolidated accounts including the consequences on the audit market was carried out in 2011 noted that given the differences and complexities in national environments, future reforms relating to audit and financial reporting could be viewed on two levels – the listed company audit requirements at a European level, and the non‐listed company audit requirements at a national level. The study goes on to say that many of the specific issues and action steps studied in the report – concentration, non‐audit services, joint audits, mandatory rotation of auditors, etc. – could be harmonised for listed company audits throughout Europe. More flexibility and options could exist for the non‐listed, national audit markets.
According to James S. Turley, former EY Global Chairman and CEO, some issues will always be national, and there’s nothing wrong with that. But when national interests trump the spirit of cross-border cooperation, it’s bad for businesses that operate globally as well as for capital markets. That seems to be what we’re seeing in the European Union right now. After more than two years of legislative wrangling, the EU adopted audit reform legislation that imposes mandatory audit firm rotation and severe restrictions on non-audit services-but that at the same time gives Member States latitude to decide on the length of rotation periods and tweak the definition of non-permissible services.
Who will be impacted?
When on 3 April 2014 the European Parliament adopted in plenary session the amended Directive on Statutory Audit and the Regulation on specific requirements regarding the statutory audit of public-interest entities, the Internal Market and Services Commissioner at the time, Michel Barnier said that the financial crisis and more recent inspection reports by national supervisors highlighted major shortcomings in the European audit sector and to address these deficiencies the Commission had made ambitious proposals in November 2011 to clarify the role of statutory auditors, to strengthen their independence, and to enhance supervision.
Many observers welcomed the agreement reached between the three European institutions. Michael Izza, ICAEW chief executive, commented: “We are glad we have a conclusion to the three and a half year long debate about how audit needs to change across the European Union. The legislation adopted today will result in big changes both for auditors and the companies they audit.
The commission proposals put forward by Mr Barnier were a response to the failure of the audit profession to warn investors of bank failures during the financial crisis. Even though some of the measures adopted are not as ambitious as in the Commission’s original proposals the reform is still wide ranging and the spirit behind it remained intact. Besides the accountancy profession, the broad community of stakeholders that rely on the quality of statutory audits will certainly feel a major impact.
The reform introduces measures that were hailed as being a landmark including the strengthening of the independence of statutory auditors, making the audit report more informative, and improving audit supervision throughout the EU. As one in a series of measures to open up the market and improve transparency, the approved text prohibits “Big 4-only” contractual clauses requiring that the audit be done by one of these firms. Moreover, the stricter requirements that will apply to the statutory audit of public-interest entities, such as listed companies, credit institutions, and insurance undertakings are expected to reduce risks of excessive familiarity between statutory auditors and their clients, encourage fresh thinking, and limit conflicts of interest.
PIEs will be required to issue a call for tenders when selecting a new auditor. To ensure that relations between the auditor and the audited company do not become too cosy, MEPs agreed on a “mandatory rotation” rule whereby an auditor may inspect a company’s books for up to 10 years, which may be increased by 10 additional years if new tenders are issued, and by up to 14 additional years in the case of joint audits. The Commission had proposed mandatory rotation after 6 years, but a majority judged that this would be a costly and unwelcome intervention in the audit market.
This notwithstanding several Member State options in the regulation allow Member States considerable flexibility regarding the length of time that an audit firm can provide audit services to a listed company, before it must rotate off the engagement. Likewise, the extent to which an audit firm within the Union can provide non-audit services to its listed audit client will depend very much on the options adopted in the EU Member State where that client is registered. To preclude conflicts of interest and threats to independence, EU audit firms will be required to abide by rules mirroring those in effect internationally. EU audit firms will moreover be prohibited from providing several non-audit services to their clients, including tax advisory services that directly affect the company’s financial statements or services linked to the client’s investment strategy. In addition, there are transitional provisions regarding a number of areas, such as audit firm rotation and the calculation of the cap on the provision of allowable non-audit services that are obtuse and difficult to interpret and hence observe.
These uncertainties place extra burdens on audit committees and costs to comply. These uncertainties run counter to the concept of a seamless market and risk increasing fractionalisation of the audit services market in the EU. In fact a recent market survey (published in May 2014), carried out by the Danish Competition Authority, in connection with a merger between the partners in the Danish firms of KPMG and E&Y concluded that there is a risk of further market concentration in the top tier audit market segment and a reduction in choice of service provider in this segment as a result of the application of the new EU legislation. This can hardly be the intent of the legislators.
Is it all bad?
One of the main objectives of the Commission in launching this reform was to “learn the lessons from the crisis” and, consequently, to clarify and define more precisely the role of the auditor.
High ranking officers of the French CNCC (Compagnie Nationale des Commissaires aux Comptes), were quoted as saying: “this was the point on which we had the most hope: the expression of a vision for a new role of the auditor in the twenty-first century. And we consider that the audit reform has forgotten this original objective. It has worked on the market, the independence, the supervision, the rules, etc… But it has not shaped a forward-looking vision for the future role of the auditor in light of the usefulness of the audit in a changing environment where the acceleration of the provision of information is dramatic and the need for trust and reliability acute. By not tackling this issue, the EU audit reform will not contribute to the reduction of the expectation gap.”
Besides the main concerns that have been expressed by members of the profession one cannot overlook what other members of the profession consider to be positive aspects of the Regulation and the Directive:
improvement of the communicative value of the auditor’s report;
the enhanced role of the audit committee; and
recognition that the audit can be adapted to serve the needs of SMEs.
Let us examine these benefits one by one.
In this first place, the primary objective of the reform is to increase the quality of the statutory audit. This means both enhancing statutory auditors’ independence and providing investors and shareholders of audited entities with better and more detailed information via the audit report.
The new rules will increase the informational value of the audit report – which is an essential tool from the investors’ perspective. Provisions spelling out the content of the audit report are set out both in the Directive and in the Regulation, as the reform differentiates audit reports for non-PIEs and for PIEs and imposes further requirements on the latter. By improving the information that the statutory auditor or the audit firm provides to the audited entity, be it a PIE or not, the reform aims to help reduce the ‘expectation gap’ that often exists between the perceptions of what auditors should be delivering and what they are bound to deliver.
Enhancement of the communicative value of the auditor’s report, which is embedded in article 28 of the Directive and article 10 of the Regulation, is part of a worldwide movement launched at the dawn of the 2008 financial crisis to respond to the demand of stakeholders to get more information from the auditor through the auditor’s report. Stakeholders know that the auditor has a deep knowledge of the entity and its environment and want to leverage that knowledge to get more information themselves. The International Auditing and Assurance Standards Board (IAASB) has been responsive to that demand and early this year, it has finalised its new audit reporting standard. The US Public Company Accounting Oversight Board (PCAOB) is also in the same process and is designing a new auditor’s report that is globally in the same vein. According to the French CNCC (Compagnie Nationale des Commissaires aux Comptes) this move was a good one because it is positive for the usefulness of the auditor’s report and the perception of the audit. Similarly the enhanced role of the audit committee was perceived as being a step in the right direction.
The additional report to the audit committee, which is to be prepared only when auditing PIEs, aims to increase further audit quality and avoid any loopholes, via enhanced communication between the statutory auditor or the audit firm on the one hand, and the entity’s audit committee on the other hand. The additional report will provide the audited PIE with more detailed information on the outcome of the statutory audit, including for instance on the methodology used, on possible significant deficiencies identified in the internal control system, on the valuation methods applied, etc. The enhanced role of the audit committee is also further recognition that the audit and the auditor is but one link in the financial reporting supply chain. But it also recognizes that properly setting the responsibilities of the audit committee is a very important element of the chain in that it serves the quality of the audit, protects the independence of the auditor and ultimately leads to better financial reporting.
As a third point, the audit reform does not impose any new burden on small and medium-sized undertakings that do not qualify as PIEs. This is in line with the conclusions presented in the “Small Business Act” adopted in June 2008 and revised in February 2011. In addition, in accordance with the new Accounting Directive (2013/34/EU), there is no requirement at EU level for small undertakings that are not PIEs to have an audit, unless Member States see the need for assurance and set up specific requirements for certain small undertakings. Under the amended Statutory Audit Directive, where a Member State requires a statutory audit for small undertakings, it has the possibility to establish simplified requirements to reduce the administrative burden for the auditor with regard to several obligations, such as the internal organisation of statutory auditors and audit firms, documentation of client records, and audit files. When a small and medium-sized undertaking qualifies as a PIE, the specific requirements governing the audit of PIEs apply. However, the audit reform also provides for a proportionate approach for small and medium- sized undertakings that qualify as PIEs, taking into account their specificities.
Not only in Europe
As the EU was in the final stages of approving the proposals, the UK Competition Commission was announcing that it will review its new audit market reform rules. These rules had only been unveiled in that last quarter of 2013. Similar to the watering down of the Commission’s audit reform proposals, the UK rules represented a retreat from what was originally expected of the Commission. Indeed critics at the time said that the rules did not go far enough to erode the cosy relationships between auditors and their clients. For example, the Financial Times reports that the British regulator had planned to require the 350 biggest listed UK companies to put their audit contract out to tender once every 5 years. In the end UK’s biggest companies will have to review their auditors only once every decade. At the time, Laura Carstensen, chair of the Competition Commission’s audit investigation group, rebutted the criticism and said the proposals would “empower the audit committee and empower shareholders in this market”.
Across the Atlantic the various IFAC Boards but primarily the International Ethics Standards Board for Accountants (IESBA) and the IAASB came under fire because its various exposure drafts (ED) failed to take into account the European reform. On more than one occasion, FEE emphasised the strategic importance of consistency between these proposed provisions and the new EU audit legislation as far as possible. A case in point is the ED on the Long Association of Personnel with an Audit or Assurance Client. In its comment letter FEE urged the IESBA to take these recent European developments into account by taking a holistic approach based on an analysis of the interaction of the different approaches that exist to mitigate the familiarity threat (e.g. mandatory firm rotation, Key Audit Partner rotation, and rotation of engagement partners and senior personnel). These concerns were also echoed in the Institute’s comment letter.
This January the IAASB released its new and revised Auditor Reporting standards, designed to significantly enhance auditor’s reports for investors and other users of financial statements. The new and revised Auditor Reporting standards will be effective for audits of financial statements for periods ending on or after December 15, 2016.
These pronouncements also come after a lengthy process that commenced in 2011 with the publication of its Consultation Paper, Enhancing the Value of Auditor Reporting: Exploring Options for Change. The IAASB’s project was welcomed on the basis that global solutions for auditor’s reports are preferable and will benefit investors and other users. FEE again drew the Board’s attention to consider the broader context of the European debate on audit policy. FEE strongly encouraged cooperation between the IAASB and the European Institutions in order to ensure that any proposed improvements are aligned on an international level: we seek a globally compatible solution that gives due credence to both the European Commission’s (EC) Proposals and ISA 700 improvements. In the absence of such satisfactory cooperation, we might end up with two different auditor’s reports, which would be very costly and diminish transparency for users. In 2013 the Board released an exposure draft to improve audit reporting. Unfortunately the EU legislation and the ED were not entirely consistent. Furthermore although the IAASB proposals were similar to the PCAOB proposals on the same subject matter, they differed in some detailed aspects.
This new EU legislation will become mandatory in the 31 jurisdictions of the European Economic Area by mid-2016. Although not everyone is equally enthusiastic about all the areas of change, everybody has now accepted that these are the new rules audit firms and companies will have to operate within. Professional accounting associations are now looking forward to support their members with implementing the new regime. At the outset the Big Four firms engaged in constructive opposition to the EU Commission’s proposed audit reforms but agree that oversight by strong, independent regulators is critical.
As observed in the article’s main text, the regulation contains as many as 21 member state options which may lead to a patchwork of rules across the EU, both in the terms of the period for rotation and which services are prohibited. Indeed as Richard Sexton, Global Assurance leader at PwC International put it, the fact that the political discussions have been finalised does not mean that work is now complete and a great deal remains to be done to ensure that the changes are implemented with clarity, consistency and the minimum of disruption and cost to business and investors. Stakeholders are now being encouraged to engage with their respective governments to input on the best possible use of the member state options.